Module I: Investment Banking and Valuation

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Module IInvestment Banking and Valuation

• September 4, 2002

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Objectives

• Understand how investment bankers value firms
• Liquidation or adjusted-asset value
• Public comparables (multiples approach)
• Discounted-cash-flow methods
• WACC (entity) approach
• Flow to equity (fundamental analysis) methods
• Adjusted present value
• Compare and contrast these methods and understand
  advantages and limitations of each

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Liquidation or Adjusted-Assets

• Value of equity in firm is simply Equity
  Assets Liabilities
• A crude estimate of value is the book value of
  equity and is used as a reference (times book)
• Adjust assets for market value rather than
  accounting values
• An adjusted estimate of equity value is Equity
  Adjusted Assets - Liabilities

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Comparables using Public Firms

• Using comparables of publicly traded firms is
  very widely used by analysts (both buy and sell
  side)
• Often called multiples approach
• Uses a combination of accounting and market
  numbers to value companies. Most common
  multiples are
• Price/earnings
• Asset/sales
• Market/book

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Example of Comparables Method

• Greens Health Inc., a privately owned Supermarket
  chain has expected earnings of 20 million per
  year on sales of 205 million with total assets
  of 80 million.
• In a proposed IPO, Greens will issue 10 million
  shares so forecast EPS is 2 per share the firm
  is all equity.
• Using data on suitable comparables, compute a
  valuation matrix

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Valuation Matrix P/E Ratios
PE Ratio
Comparables
Implied Stock Price
Vons 18 Safeway 19
36 38
Average
18.5
37
Source Compustat (Wharton) Raios for 1995
Using an average stock price of 37, firm value
is estimated to be 25 ? 10m 370 million
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Valuation Price/Sales Ratios
P/S Ratio
Comparables
Implied Firm Value
Vons .24 Safeway .38
49.2 77.9
Average
1.3
63.6
Firm value is estimated to be 63.6 million
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Valuation Market/Book Ratios
M/B Ratio
Comparables
Implied Firm Value
Vons 2.0 Safeway 6.9
160.0 552.0
Average
1.3
356.0
Firm value is estimated to be 356.0 million
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Compare Results

• Range of values is 63 to 360 million
• Wide differences in Vons and Safeways ratios
• What are differences in firms and how do they
  affect comparability of valuations?
• Vons has debt-to-asset ratio of .66
• Safeways debt-to-asset ratio is .82
• Both firms are highly leveraged
• P-E and P/B valuations are closer than P/S
  approach

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Pitfalls in Comparables I

• Remember when using P/E ratios that the estimated
  value is the value of equity, not firm value.
• Example
• Suppose Greens carried 114 million of debt.
  With equity of 250 million and debt of 114,
  firm value is now V E D 364 million.
• How does this affect value using P/S ratios?

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Pitfalls in Comparables II

• Are the comparables really comparable? Firms
  differ in many significant dimensions including
• Growth rates
• Cash flows
• Risk (most obviously capital structure note that
  Greens equity value was unchanged by the fact
  that it carried debt. Is this realistic?

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Pitfalls in Comparables III
Suppose the unobserved true relation between
stock price and earnings is
Price 9.00 12?EPS
For Vons, say EPS 1.50, so Price 27 and P/E
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For Greens, we have value 9.00 12 x 2
33 The multiples approach misprices by 4.00 or
twelve percent of firm value -- other relations
could be off more.
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Assessment

• Advantages
• Quick, easy to understand, and widely used
• Disadvantages
• Based on accounting concepts
• Ignores growth opportunities and future cash
  flows
• Fails to account for differences in capital
  structure

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DCF Approaches

• All DCF approaches discount cash flows by the
  appropriate discount rates
• Ingredients
• Cash flow forecasts for future periods (the past
  is irrelevant)
• An associated discount rate which measures the
  return on investments of comparable risk
• Three main approaches
• WACC, APV, Flow to Equity

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DCF Approaches

• Simplest approach is to assume first-year cash
  flow and perpetual growth and discount rates
• More convincing approach is to use explicit cash
  flow projections over a forecast period and
  discount continuing value using simplest approach
  for cash flows after forecast period

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Computing the Discount Rate

• The discount rate applied to these cash flows
  represents the opportunity cost of capital
• It can also be thought of as the expected or
  required return for an investment that is equally
  risky

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Equity Discount Rates

• Unlevered Cost of Equity (rA)
• What the cost of capital would be if the firm had
  no leverage.
• Depends on asset risk, but not not capital
  structure
• Equals weighted-average cost of capital (WACC)
• Levered Cost of Equity (re)
• Cost of equity capital at a given leverage.
  Clearly depends on asset risk and also on
  leverage.

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Discount Rates

• We obtain discount rates for equity using a model
  of risk such as the CAPM
• CAPM states that the expected or required return
  on an asset the sum of two components
• The risk free rate
• A risk premium
• The risk premium is b times the market risk
  premium, historically about 8

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CAPM
The Capital Asset Pricing Model states that the
expected return on an asset is
Beta measures the sensitivity of the stocks
return to the return on the market portfolio.
Note that beta depends on the firms leverage.
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Next Week September 9 and 11

• Be prepared to discuss Eskimo Pie case
• Review textbook discussion of capital structure
  and the issues of capital structure and corporate
  valuation
• Read Continental Carriers Inc. case to
  familiarize yourself with the issues and data
  available